Materials Stocks: One to Buy, One to Sell

by Will Ashworth | August 15, 2013 9:45 am

Materials Stocks: One to Buy, One to Sell

What’s the worst of the S&P 500? Materials.

Yardeni Research provides performance updates[1] for all 10 sectors of the S&P. Along with telecom services and utilities, materials stocks have achieved one of the worst performances year-to-date through August 13 — up just 9.8% compared to 18.8% for the index itself.

Industries within that sector that are performing poorly include aluminum, mining and steel. But are they all doomed, or can some stocks stage a comeback? I’ve got one stock to buy and one to sell from the bunch.

Stock to Buy

What the heck is a “proppant[2]?” As InvestorPlace contributor Aaron Levitt would tell you, it’s a fancy name for sand and man-made ceramic materials. When combined with a fracking fluid such as guar gum, a proppant is able to widen cracked shale fractures, allowing more oil and natural gas to flow out. It ain’t glamorous, but it’s absolutely essential to the success of Marcellus, Utica and other shale plays across the U.S.

Hi-Crush Partners LP (HCLP[3]) is a pure-play, low-cost domestic producer of this essential ingredient. Formed in 2010 by experienced oil services industry personnel, HCLP went public August 15, 2012 — almost one year ago to the day. Since its IPO at $17, the stock is up 37.2% through August 1, HCLP provides investors with a very attractive annual distribution of $1.90; those distributions are expected to increase by at least 19 cents in fiscal 2014 for a yield of 9.3%.

When it comes to investing, boring is better. That’s good news for HCLP investors, because frac sand is definitely not cocktail party material.

In June, HCLP completed its $125 million acquisition of D&I Silica, LLC. D&I is a leading distributor of sand to the oil and gas industry in the U.S. with 11 terminals in Pennsylvania, New York and Ohio. Its extensive materials handling experience gives HCLP a leg up on the competition, not to mention a wider distribution network for its frac sand.

In addition to its wholly owned facility in Wyeville, Wisc., HCLP acquired a preferred interest in 2012 in another production facility in Augusta, Wisc., for $37.5 million and 3.75 million convertible Class B units representing limited partner interests in the partnership.

Together, the two facilities have annual capacity of 3.2 million tons. Under long-term contracts, the company makes about $64 per ton, and at 100% capacity, each facility is capable of generating slightly more than $100 million annually. In order to grow, Hi-Crush will have to acquire additional reserves, so you can expect it to add to its debt in the coming years. But that shouldn’t be much of a concern, as the company generates significant free cash flow.

But when considering an investment in Hi-Crush, the fly in the ointment is the future of fracking itself. Most jurisdictions within shale formations in the U.S. have serious concerns about whether the huge amounts of water[4] necessary to produce oil and natural gas can be safely disposed of. I believe technology will find a way to deal with one of mankind’s most valuable resources. Nonetheless, an investment in HCLP must be made with an understanding that a ban on fracking virtually puts an end to its business overnight.

It’s a risk that might be worth taking, but one that shouldn’t be forgotten or ignored. If you’re an income investor, HCLP has to be on your “buy” list.

Stock to Sell

This decision isn’t as easy as it might seem. Materials stocks have experienced significant weakness at times in 2013, but the contrarian in me realizes that every worm has its turn. At some point the sector will recover, and when it does, I don’t want to be on the wrong side of that recovery.

I’m looking for an industry that’s hurting and likely to stay that way. It’s tempting to think gold — it had its day in the sun already — but the more I think about it, I see the coal industry as the big loser in the next 12-24 months as natural gas continues to grab more market share in electric power generation.

It’s not going to happen overnight, mind you. During the past year, coal regained some of the market share[5] it has been losing to natural gas since 2007. As more power generation systems switch to natural gas, price rises due to increased demand — economics 101 stuff — and electricity producers move to coal in order to lower their costs.

It’s a temporary panacea. Once natural gas producers acquire the technology to safely drill for natural gas, the reserves in shale basins across the U.S. will supply domestic energy needs for hundreds of years. And even if they can’t, some other energy source that’s cleaner than coal will come along in the place of natural gas. It might take a century or more, but it’s going to happen.

So …which coal producer should you shun?

All of them.

As crazy as it sounds, I’m suggesting that you short the Market Vectors Coal ETF (KOL[6]), which seeks to replicate the overall performance of the global coal industry. Not every one of the 34 holdings is a coal producer — Joy Global (JOY[7]) is a top-10 holding — but many are, including Peabody Energy (BTU[8]) and Alpha Natural Resources (ANR[9]).

Since its inception in January 2008, KOL has achieved an annualized total return of −12.8%, considerably worse than the S&P 500. Despite my general belief in reversion to the mean, I believe the coal industry will continue to face much pain. In this situation, a lowering tide strands all boats. For those who actually own this ETF, I’d seriously reconsider your position.

Coal is going down — it’s only a matter of time.

As of this writing, Will Ashworth did not own a position in any of the aforementioned securities.